REIT that delivers.

We maintain our BUY call on Manulife US REIT (MUST) with a revised Target Price of US$0.97.

Hallmarks of a successful real estate investment Trust (REIT) include management that delivers on their promises and owning properties with strong fundamentals. Since its listing nearly 2 years ago, MUST has delivered with distribution per unit (DPU) exceeding IPO forecasts, property values increasing by over 10%, and the ability to identify DPU-accretive acquisitions.

With the recent US tax cuts expected to spur economic activity and demand for office space, we believe MUST remains an attractive investment, with its original investment thesis of rising rentals and improving capital values remaining intact.

Where we differ: Premium to book.

While consensus is bullish on its US exposure, pegging target prices at P/Bk of c.1.10x, we believe MUST deserves to trade at a higher P/Bk of c.1.20 given its ability to execute on DPU-accretive acquisitions and upside risks to its portfolio values as the US office market remains on an upcycle.

Moreover, a premium is justified, as DPU growth over the next 2 years is 2-3 times higher that of other S-REITs.

Acquisitions to be growth drivers.

We understand markets that are of interest are core submarkets that enjoy demand from diversified industries (i.e. manufacturing, financial, technology and law firms) which imply stability across market cycles.

Valuation:

After incorporating the latest acquisitions and rights issue, we lower our DCF-based Target Price to US$0.97 from US$1.00.

Key Risks to Our View:

The key risk to our view is lower-than-expected rental income, arising from non-replacement/ renewal of leases and/or slower-than-expected recovery of office rentals in the US.

WHAT’S NEW: Rights issue for acquisitions

Funds recent acquisitions with 22 for 100 rights issue

In April, Manulife US Real Estate Inv (MUST) announced a sale and purchase agreement with its sponsor to acquire two properties - 1750 Pennsylvania Avenue in Washington DC (Penn) and Phipps Tower in Buckhead, Atlanta (Phipps) - for a total purchase price of US$387m, at a 1.8% discount to two independent valuations by Cushman & Wakefield and Colliers.

Penn and Phipps were acquired on a cash net property income (NPI) yield of 5.2% and 5.9% respectively. Total consideration including acquisition fees (US$2.9m) as well as professional fees (US$9m), amounts to US$398.9m.

At the time, it was not decided whether MUST would acquire the properties via the issuance of perpetual securities or equity-raising in combination with onshore USD debt at c.4.25%.

Subsequently, MUST decided to launch a non-renounceable rights issue, on the basis of 22 new units for every 100 existing units at an issue price of US$0.865. Gross proceeds were c.US$197.2m.

1750 Pennsylvania Avenue (Penn) overview

Penn is a 13-storey Class A freehold office building located a block away from the White House and was constructed in 1964. It was renovated in 2012-2018 at a cost of c.US$6m and has a total net lettable area (NLA) of 277,243 sq ft.

Occupancy as at 31 December was 97.2%, with a long weighted average lease expiry (WALE) of 6.8 years.

The property is predominantly leased (86.2% of tenants) to the US government and global agencies. The two largest tenants are the US Department of Treasury and the United Nations Foundation which contribute 41.7% and 37.4% of gross rental income (GRI) respectively.

Near term expiries are limited (0.5% of leases by GRI) in 2018 and 0% in 2019) with a large proportion of leases due in 2020 (7.2% of GRI) and 2022 (41.7% of GRI). Leases in the building have inbuilt rental escalations either mid-term or on an annual basis (2- 3%).

Phipps Tower (Phipps) overview

Phipps is a 19-storey trophy quality office tower with 475,091 sqft of NLA. It is located in Buckhead, one of the primary and strongest business districts in Atlanta. Phipps was initially developed by MUST’s sponsor and completed in 2010.

The building will be purchased for US$205m and is close to fully occupied (occupancy of 97.3%).

Phipps is currently a leasehold property but will be converted into a freehold property in 2 years upon the payment of US$100. The property was initially classified as a leasehold property to gain property tax relief which reduces over time. However, MUST will not be impacted by higher property taxes in the near term, as leases are triple net in nature and borne by the tenants.

Key tenants include Carter’s (64.6% of GRI) a major American designer and marketer of children’s apparel listed on the NYSE, Northwestern Mutual (12.6% of GRI) a financial services company, and CoStar (9.9% of GRI) a commercial real estate information and marketing provider.

Similar to Penn, Phipps has a long WALE of 10 years with over 90% of leases by NLA and GRI expiring in 2023 and beyond. Majority of the leases have built-in rental escalations typically mid-term or periodic, ranging from 1-3% per annum.

The property is also under rented, with passing net rent of US$22.20 psf vs market net rent of US$30.0 psf. The low passing rents reflects the fact the leases were predominantly signed during the global financial crisis (GFC).

In addition, we understand that anchor tenant Carter’s has a break clause that can be triggered in 2025 with a 12-month notice period. However, as we understand their rent is close to Phipps average passing rent, we believe the likelihood for Carter’s to break the lease is low.

Investment rationale

Beyond income diversification, a key rationale for the acquisition of Penn is the exposure to the central business district (CBD) Washington DC office market, which historically has shown resilience. In addition, the property itself is on Pennsylvania Avenue - a preferred address for high profile law firms, global agencies and political think tanks.

For Phipps, the Atlanta market, which MUST already has exposure to through its Peachtree property, is a growing market given the attractive dynamics for corporates to expand their operations. Atlanta is one of lowest cost cities in the US to do business, has an educated workforce anchored by several universities and is a major transportation hub with Hartsfield- Jackson International Airport being the world’s busiest airport. The Buckhead submarket, which Phipps is located in, also has the added benefit of being the strongest submarket with rents having grown by 58.4% since 2012.

Market Outlook

CBD Washington DC submarket

The CBD Washington DC office market where Penn is located has experienced stable vacancy rates over the past 3 years at around 10%, having fallen from 13.2% in 2012. The 10% vacancy rate is lower than the 16.6% vacancy rate for the overall Washington DC market.

However, rents have been increasing over the past 3 years, as the older Grade B and C office buildings are being redeveloped. This has resulted in stock temporarily being taken out of the market. Due to the high costs of redevelopment, the owners of these buildings have pushed asking rents higher, which also pushed tenants towards Class A buildings such as Penn.

Heading into 2018 and beyond, we understand the market is expected to remain relatively stable as there is limited new land available for the development of new office products and demand remains steady.

Buckhead submarket

The Buckhead submarket in Atlanta, where Phipps is located, traditionally attracts financial institutions and consumer goods companies with the highest rents in Atlanta. In contrast, Midtown (where MUST’s other property Peachtree is located) is a market that attracts law firms and tech companies.

In terms of market dynamics, Class A rents have been on an upward trend on the back of a decline in Class A vacancy rates from over 20.1% in 2012 to 14.8% in 2017. However, over the past year, vacancy has increased from 12% in 2016, largely due to the completion of a new building which is now close to 90% leased. Going forward, with healthy demand vacancy rates are expected to normalise with higher rents ahead.

Fortifies portfolio, despite near term drag

After incorporating the acquisitions of Penn and Phipps and higher borrowing costs, we lowered our FY18-21F DPU by 1-11% and reduced our DCF based Target Price to S$0.97 from S$1.00 largely due the additional units from the recent rights issue.

While the rights issue had the impact of diluting our DPU estimates (compared to the potential issuance of perpetual securities), we believe the majority of unit holders would have preferred this option given gearing (total debt/total assets) will now stabilise at around 37% level rather than rise above 40% (assuming 50% of the perpetual securities were treated as debt, as per treatment by the rating agencies).

Overall, we remain positive on the benefits of the acquisitions. These include the increased resilience of the portfolio as MUST’s WALE has been extended with high quality tenants, as well as potential upside in rents given that the two properties are under rented.

Maintain BUY with revised Target Price of S$0.97

We believe the correction in MUST’s share price over the last couple of months is an opportunity to gain exposure to the upturn in the US office market and a portfolio of quality buildings managed by a reputable, blue-chip management team and sponsor.

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